Why Hedge Funds Are Now Avoiding Nokia

Nokia Corp (NYSE:NOK) made a decision on Monday to lower the price of its flagship phone Lumia 900 to $50 dollars with a two year contract. Struggling sales across its mobile U.S. carriers [AT&T (NYSE:T) and T-Mobile] have put Nokia in a tough position to compete with powerhouses such as Apple (NASDAQ:AAPL) and Samsung (OTC:SSNLF). The Lumia 900 was designed to buck the trend of Nokia's low-margin phones. Designed to be a feature-filled phone that excited consumers, the lackluster sales for its flagship phone are concerning.

Nokia's stock has fallen from a high of $40 in 2007 to its current trading price of $1.80. Few hedge funds are long the stock, and the ones that are have made very small bets. Nokia reported a loss of $1.7 billion in Q1 2012, and a 52 percent decline in smartphone sales compared to the previous year. Revenues declined to 9.7 billion in Q1 2012, down from 13.6 billion in Q1 2011. We previously discussed Nokia in a list of dividend stocks that hedge funds are interested in, but considering Nokia is operating at a significant loss, there's a probable chance that the dividend might be reduced or cut.

While Nokia is still the world's second largest vendor of mobile phones [behind Samsung], many of Nokia's phones are low-priced and low-margin products that are difficult to drive the bottom line. There have been a few costly mistakes that resulted in lower earnings, lower market share and uncertainty about Nokia's future. These mistakes were varied, but they were also repeated for far too long.

Mistake 1: Nokia stayed on its Symbian Platform for far too long.

Before market share was dominated by Android and iOS, mobile phones often created its own platforms. Nokia's mobile platform was Symbian. Symbian wasn't a horrible platform; it just wasn't anything that excited consumers. Nokia held top market share of mobile phones from 1998 to 2012 (until Samsung took the spot), and for most of that period Nokia felt Symbian was enough.

However, when other competitors began adopting Google's (NASDAQ:GOOG) Android, Nokia refused to look at what Android had to offer. Android began obtaining market share and by Q4 2010, the amount of Android users had surpassed Symbian. This was also a period where Nokia saw its decline in its worldwide market share from 44.4% to 30.6%. It was only until February 2011 that Nokia announced it would enter a strategic partnership with Microsoft and the use of Windows Phone 7 for its mobile operating system for future phones.

Mistake 2: Assuming Microsoft was enough to save Nokia.

The strategic partnership that Nokia entered with Microsoft (NASDAQ:MSFT) meant Nokia would use Microsoft's mobile OS for all of its phones. On a cursory glance, it made sense. Nokia was able to beef up its operating system; Microsoft would get exclusivity to largest phone maker in the world. The problem? Consumers don't go to an AT&T store for a Windows Phone. Nokia was betting that Microsoft's 2% market share of the mobile space would motivate them, yet the unfamiliarity with Microsoft's WP7 made it difficult to retake market share from Android / iOS.

Mobile phone purchases are frequently decided by "influencers." Consumers ask friends and family for recommended phones prior to purchases. WP7 scored highly on reviews, yet the same influencers continued to recommend iOS and Android phones. Microsoft's slow uphill struggle for recognition and familiarity has hurt Nokia.

On the contrary, adopting WP7 wasn't a bad decision. The mistake was not doing enough. Adopting WP7 made Nokia different from the other "me-too" Android phone companies, but both Nokia and Microsoft failed to execute on the brand. Nokia's Lumia 900 is a superb well-reviewed phone. It was sold out the first month it was released, but a few months later we find ourselves with a price cut for lackluster sales. Great initial momentum, but missing a big finish.

Mistake 3: Complacency until it was far too late.

Motorola and Research in Motion (RIMM) are other phone makers that lost their dominant position in an industry that has quickly shaped up to be as competitive as the PC sector. Both Samsung and Apple have a choke-hold on the high-end profitable smartphones, whereas everyone else is fighting for the crumbs.

While apparent now, this couldn't have been farther from the truth back in 2007. Steve Jobs had just announced the IPhone, Samsung was barely on the radar, and Nokia was the top seller in mobile phones. Then, Nokia proceeded to waste years of development on mediocre and non-memorable phones that saw its dominant position slip away. Its willingness to watch market share erode and difficulty with creating innovative and exciting products let it fall into being a low-margin supplier of phones.

Nokia's Lumia series are definitely a step in the right direction of creating a well-rounded product, but this product for as well-reviewed as it is, feels a little too late to the game.

How can Nokia recover?

Motorola, acquired by Google in May 2012, bet heavily on being acquired (largely due to hedge funds activists such as Carl Icahn, (see Icahn's Favorite Stocks). The acquisition required Motorola to split into Motorola Mobility (NYSE:MMI) and Motorola Solutions (NYSE:MSI). It took largely two years. It would be difficult for any company to acquire Nokia due to complex international laws.

Research in Motion is making a final bet on Blackberry 10 as its unifying operating system. RIM is betting that Blackberry 10 and its new phones will excite consumers to go back to the brand. (see our analysis of RIM and the value trap).

What is Nokia's long term strategy? While some of the sentiment is WP8 (the next version of Windows Mobile Operating System) will help spearhead Nokia sales, considering the difficulty WP7 has with generating sales for Nokia now, what makes investors think that this operating system will be different? To add oil to the fire, Nokia's current phones cannot support WP8.

Nokia's market share on low-end and low-margin phones will also be difficult to continue. Prices of Android phones have dropped dramatically in emerging markets due to competition from China-based mobile phone company ZTE (OTCPK:ZTCOF). The smartphone industry is a difficult industry where players are being forced out. Without a clear-cut strategy on where to go next, this could be Nokia's biggest mistake of them all.

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